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How to Prepare for a Retroactive Capital Gains Tax Hike

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What You Need to Know

  • CPA Sheryl Rowling, who heads rebalancing solutions for Morningstar, offers some pointers.
  • Consider moving up future big multimillion-dollar sales into this year.
  • Structure future deals as installments to keep annual income under $1 million.

What if the Biden administration’s proposal to raise the capital gains tax on high-income taxpayers was retroactive to April 28, the day it was proposed as part of the American Families Plan, or to May 28, the date the Treasury Department released the administration’s proposed fiscal 2022 federal budget?

Either is possible since the Treasury Department noted in the budget, aka the “Green Book,” that its proposal on capital gains “would be effective for gains required to be recognized after the date of announcement,” which could refer to April 28 or May 28.

Jeffrey Levine, chief planning officer at Buckingham Strategic Wealth, wrote in Forbes recently that although “it’s clear that the Administration has its sights set on retroactively increasing the capital gains rate … [but] it’s highly unlikely that the proposed capital gains changes will be enacted retroactively” by Congress, which will ultimately decide the issue.

Levine explained that such a change is not very politically feasible to undertake in the third quarter, when more than half the year has passed.

CPA Sheryl Rowling, who heads rebalancing solutions for Morningstar, isn’t so sure. “It is true that we don’t know what will make it into law,” wrote Rowling in a recent Morningstar column. “However, the fine print of what has already been proposed could mean when it comes to capital gains taxes, the effective date after which these increases would be in force has already been passed.”

Biden’s Capital Gains Tax Plan

Under the Biden plan, capital gains for those earning more than $1 million would be taxed at their marginal tax rate, which is currently 37% and which the administration hopes to increase to 39.6% in 2022. Those taxpayers would also have to continue paying the 3.8% Medicare surtax on capital gains, bringing the total levy to 40.4% in 2021 and 43.4% in 2022.

The key to avoiding the higher capital gains tax is to keep income below $1 million, writes Rowling. Then she offers several scenarios for advisors and others to consider to help high-income clients plan for the possibility of higher capital gains taxes applied retroactively. She stresses that any pre-emptive moves should not inflict harm if the tax hike doesn’t pass, which is also a possibility.

The scenarios assume that the higher capital gains tax is retroactive to late April or late May 2021. They involve a hypothetical client who earns more than $1 million and would thus be subject to the higher capital gains if he or she sold a business for $10 million in 2021, anticipates such a move in the future or was collecting installment payments from a 2020 sale.

The client’s capital gains would be taxed at their ordinary income marginal tax rate, which is 37% for 2021 but would rise to 39.6% in 2022 under the Biden budget plus the 3.8% Medicare surtax. That brings their total capital gains tax up to 40.8% in 2021 and 43.4% in 2021, from 20% currently.

A Multimillion-Dollar Sale in 2020

If the sale proceeds are being paid out in increments over several years, Rowling suggests the taxpayer elect out of the installment tax payment plan and pay the full tax liability this year. They have until Oct. 15 to do so. Even if the capital gains increase is retroactive, they would still save money because the capital gains would be based on a 37% marginal tax rate instead of 39.6%.

A Multimillion-Dollar Sale, No Date Set Yet

If the $1 million-plus earner is planning a big sale sometime soon, they should consider doing it this year instead of next year for the same reasons noted above for a 2020 sale paid in installments. That would save a taxpayer $260,000 on a $10 million sale.

The taxpayer should also use other traditional methods to reduce their tax liability including increasing retirement plan contributions, deferring other income, purchasing properties that can be expenses, harvesting tax losses and making charitable contributions, including securities, to a donor-advised fund.

“Use whatever trick you have up your sleeve to lower taxable income,” says Rowling. “That will lower the amount of capital gains subject to ordinary income taxes.”

A Multimillion-Dollar Sale This Year or in the Future

Rowling suggests structuring any such sale to keep as much as its proceeds, combined with a taxpayer’s income under $1 million for any given year to avoid the higher capital gains tax. A $10 million sale this year, for example, could be structured for a $5 million upfront payment this year, subject to the current 37% income tax rate plus Medicare surtax, and lower payments in subsequent years to hopefully keep total income under $1 million. The taxpayer could also contribute $1 million in securities, up to maximum 30% that can be written off, to a donor-advised fund this year to reduce the capital gains subject to the higher tax.

For future sales, they can string out payments, which, combined with other tax-saving moves, can help keep their income under $1 million and thus pay just 20% on their capital gains instead of their higher income tax rate.

The key is planning. “Even though Biden’s tax proposals are not certain to become law, the retroactive effective date of some of the provisions make planning essential,” writes Rowling. “Consider strategies that will not be disadvantageous should the proposals not be enacted.”


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